Market capitalization weighting of financial market indices is common because it results in indices that are macro-economically consistent. Market capitalization weighting is consistent with a passive buy and hold strategy and is market-clearing. Also, according to the Capital Asset Pricing Model (CAPM), a capitalization weighted market portfolio is the only mean-variance portfolio of risky assets that is of interest to investors.
However, the notion that capitalization weighted indices are mean variance efficient has been questioned. In the presence of price-inefficiency (informational inefficiency) capitalization-weighting may systematically overweight securities that trade above their fair value and underweight securities that trade below the fair value, thus resulting in capitalization-weighted indices that are inefficient.
Various alternatives to capitalization-weighting have been suggested and used. Some other ways of weighting securities in an index include price-weighting (Dow Jones Industrial Average), equal weighting (Standard & Poor's), factor and GDP weighting (MSCI).
Proponents of fundamental weighting schemes have illustrated that indices that use weights that are derived from a company's historical fundamental information such as gross revenue, equity book value, gross sales, gross dividends, cash flow and total employment deliver better mean-variance performance, ex-post, relative to capitalization-weighted indices.
However, one issue with using historical fundamental information is that it is based on history. Thus, companies which have grown in the past and have large book values or revenues will get a bigger weight in indices constructed using historical fundamental values weighting. Equity markets, however, are forward-looking and discount the future. Thus indices that are constructed using historical fundamental values weighting alone may not be appropriate as benchmark indices which can be used for asset allocation, performance evaluation, etc as they reward only past size and growth in the fundamental factor used for weighting. Such a security weighting scheme, if used for an investment strategy or in portfolio construction, also would rely entirely on past realizations of fundamental values. By contrast, market capitalization weighting, because it is based on prices which reflect expectations about the future, favors future valuations exclusively.